Whatever the result of Britain’s upcoming in-or-out referendum on EU membership, its relationship with the EU will change substantially. To assess these changes, it is important to understand how Britain has benefited from EU membership. This column argues that EU membership has brought benefits through three key mechanisms – trade, foreign investment, and finance. The current focus on UK exports to and imports from the EU may severely underestimate the true potential costs to Britain of Brexit.

As if terrorism, refugees, Schengen, debt, and Greece were not sufficiently big worries in each of themselves, the EU now has also to face the “English Question”. A referendum on Britain’s EU membership will take place before the end of 2017 (Copsey and Naughton 2014). In or out, remain or leave, the relationship between the UK and the EU will change dramatically.1 In order to assess such changes, one needs to grasp not only the reasons that led Britain to join the EU, but also how the UK has benefited from EU membership. In this column, we focus on the latter by trying to identify key channels. We argue that Britain benefited significantly from EU membership – the three key mechanisms were trade, foreign direct investment (FDI), and finance, though in ways that are seldom discussed. In this column, we:

Put forward the infrequent argument that trade is good for UK growth but that intra-industry trade is good for UK TFP growth and hence may matter even more;

Present the first estimates (that we know of) of the causal effect of EU membership on UK FDI net inflows; and

Argue that the benefits of financial services specialisation in the UK depend a great deal on their interactions with FDI and trade.

Joining up is hard to do

Why did Britain join the European Community? In a companion column (Campos and Coricelli 2015), we analyse the evolution of the ratio of UK GDP per capita to that of the six founding members of the EU, since 1950. We report econometric evidence for a structural break circa 1970. Although explaining this break requires multiple factors, it is clear that EU membership played a substantial part.2

Campos et al. (2014) estimate net benefits to the UK from EU membership to be positive but, until around 1986 (Single Market), relatively small. Measured in terms of per capita output, net benefits peak around 1992 and remain constant until 2010. On the other hand, net benefits in terms of labour productivity (GDP per worker) increase year after year from 1992 until 2010.3 What factors related to European integration may have contributed to the dynamics of these net benefits? We argue that the answer lies in trade, FDI, and finance, although in ways seldom discussed to date.

Figure 1. UK net benefits from EU membership

Source: Campos et al (2014).

Trading up is hard to do

Article 2 of the 1957 Treaty of Rome sets a common (single) market as a main goal of the European integration project (Sapir 2011.) Trade in this project would serve a dual purpose – it would deter violent conflict (Martin et al. 2012) and would fuel economic growth. The benefits of trade are one of the few items that command widespread agreement among economists. Trade openness is associated with increasing competition and technological innovation, which lead to welfare improvements and growth.

Did joining the EU increase the UK’s trade openness? Yes it did, but in an unexpected way. The UK actually experienced a step change in the level of trade openness when it joined in 1973. According to the latest Penn World Tables (PWT) trade openness data, from the late 1950s to 1970, the UK averaged about 40%, rising to about 55% for 1973-2010.4 One usual explanation is that the economy specialised in services. The latest UNCTAD data in Figure 2 reveal the limits of such reasoning. Trade in services have grown at very much the same rate (from rather similar initial levels) in both the UK and Eurozone countries. Yet for trade in goods one observes divergence instead.5

Figure 2. Trade openness (as % of GDP) in the UK and the Eurozone, 1980-2013

Source: UNCTADstat.

If not trade openness, then what? The answer is perhaps intra-industry trade.6 Reaching the limits of overall trade openness among the EU6 (intra-EU6 trade increased from about 35% in 1958 to 50% in 1973) was accompanied by a substantial rise in intra-industry trade. The increases range from 42% in 1958 to 57% in 1973 in Italy, to an increase from 62% to 72% for the same period in the Benelux countries. Although intra-industry trade increased globally (Bullhart 2009), the fact that Western Europe starts from a relatively high level does not make its progress less impressive.7 UK intra-industry trade experienced massive changes around 1973 – average levels rose from less than 50% in the 1960s to more than 70% in the late 1970s and beyond (OECD 1987).

The main argument is that trade is beneficial, but inter-industry trade even more so. This argument has been largely ignored so far. Trade with the Commonwealth surely increases UK GDP, but trade with the EU is good for UK GDP and also (and more importantly) for UK TFP. Commonwealth trade is mainly inter-industry, thus driven by comparative advantage (hence gains from trade are mostly from specialisation and scale), while EU trade, by being mostly intra-industry, generates gains that are basically driven by increased competition and technological innovation. One expects the impact of the latter on UK productivity growth to be more substantial and longer-lasting.

Foreign capital

The benefits of foreign direct investment are well-established. Not only does FDI contribute to the diffusion of frontier management practices, increase competition and shore up technological innovation, but it does all this in a relatively more-resilient and sustainable fashion (than, for example, portfolio investment).

The UK is one of the main FDI recipients in Europe. Net FDI inflows to the UK were small until the mid-1990s but exhibit two periods of rapid expansion – one in the second half of the 1990s and the other before the financial crisis. Meanwhile, the share of FDI into services has increased (Driffield et al. 2013). Despite the obvious importance of the subject and the availability of evidence contrasting the rationales of European and non-European intra-EU FDI (Basile et al 2008), the literature focusing on potential reasons for foreign investors to choose the UK vis-à-vis Germany or Ireland remains scarce. Yet, European integration may have played a significant role.

Figure 3. What would UK FDI net inflows look like had the UK opted-out of the Single Market in 1986?

Source: Authors’ estimation based on World Bank (WDI) data.

Figure 3 presents estimates of the effects of the launch of the Single Market in 1986 on UK FDI net inflows.8 The red line shows our estimates for what would have been FDI net inflows after 1986 if the UK had decided to opt-out of the Single Market. The results clearly show that the Single Market played a key role in mobilizing FDI to and from the UK. Perhaps even more interesting is the suggestion that the bulk of these benefits (in terms of additional UK FDI had the UK chosen to opt out instead) happen post-euro, between the dotcom bubble and the Global Crisis. It is also worth noting that net FDI inflows to the UK seem much more volatile than one would expect (maybe reflecting the high share of the more ‘footloose’ service sector). Finally, these results also indicate that the Single Market stop being such a powerful magnet after 2009, although the net costs since are clearly small vis-à-vis previous gains.

Financial links

There is consensus on the fact that the UK benefited from EU membership through the positive impact of EU integration on the development of the UK financial sector. The relevance of the EU for the UK financial sector cannot be underestimated. Access to the EU Single Market contributed to strengthening the position of the UK as a leading international financial centre.

London has traditionally been the main centre for foreign exchange transactions. However, since the beginning of the 1990s, the share of the UK in foreign exchange transactions has sharply increased, from 25% to more than 40% of the world market.9 Note that foreign exchange, with daily transactions of more than $US6 trillion in 2013, accounts for the largest amount of overall global financial transactions. Although the US dollar still dominates, the euro accounts for more than one third of foreign exchange transactions. As shown in Figure 4, the UK has substantially gained shares in foreign exchange at the expense of the main Eurozone members, Germany and France, but also at the expense of Switzerland. Technological factors may explain such phenomenon, but the fact the UK is a EU member certainly played a role.

Figure 4. Foreign exchange turnover: Country shares in total transactions

Source: BIS (2015).

Clearly, access to the EU Single Market has been one main factor in consolidating the role of the UK as an international financial centre. The comparative advantages of the UK financial sector (tradition, flexible regulation, product diversification, human capital, language, etc.) help the UK to exploit the benefits of EU integration. It is worth noting that, despite being outside the common currency, the UK remains by far the largest player in euro-denominated transactions in the EU.

Conclusions

Focusing on three main areas (trade, FDI, and finance), we argue that Britain benefited significantly from EU integration. Leaving the EU (“Brexit”), it is likely to entail heavy losses (Ottaviano et al 2014) and we expect the severity of these economic losses to increase substantially after the consequences in terms of intra-industry trade, FDI and financial integration are taken into account.

And yet these losses may be even larger when we account for interactions among the three areas. These interaction effects should be large for the relationship between FDI and trade (because intra-industry trade often involves FDI), between financial integration and intra-industry trade (because intra-industry trade is credit intensive; Giannetti et al 2011), and between financial integration and FDI (because FDI in the UK concentrates in financial services.)

Further research on these issues is urgently needed as the current (and almost exclusive) focus on ‘UK exports to and imports from the EU’ may severely underestimate the true potential costs of Brexit. Time may be ripe to paraphrase Churchill – European may be the worst form of integration, except for all the others.

Exit from the EU may have particularly severe effects on the UK financial sector, and through these, on trade and FDI. True there are already pressures within the EU to reduce the relevance of the UK as the main financial centre for euro transactions. However, exiting the EU minimises how the UK can influence these decisions. In March 2015 the UK won an important legal battle against the ECB on the location of euro clearing houses, thanks in large part to its EU membership. It is unreasonable to expect the UK will be granted such powers if it chooses to leave the EU.

References

Abadie, A and J Gardeazabal (2003) “The economic costs of conflict: A case study of the Basque country,” American Economic Review, 93: 113–132.

Sapir, A (2011) “European integration at the crossroads: A review essay on the 50th anniversary of Bela Balassa’s Theory of Economic Integration,” Journal of Economic Literature, 49:4, 1200–1229.

Footnotes

1 One can also argue that the EU itself will change dramatically, especially if the so far inexistent ‘associated membership status’ is created and offered to the UK.

2 In addition to the lacklustre performance of the free trade area (favoured by EFTA) vis-à-vis the custom union integration model and De Gaulle’s resignation, Britain joined principally because joining the European project was a way to halt its relative economic decline (Crafts 2012). In 1950, UK’s per capita GDP was almost a third higher than the EU6 average; in 1973, it was almost 10% lower but it has been comparatively stable ever since (hence the structural break).

3 The international evidence on productivity suggests an upward trend break for the US in the mid-1990s and, at round the same time, a downward break for the Eurozone (Bergeaud et al. forthcoming).

4 In fact, the 1972 value of this ratio is 42.46% while for 1974 it is 58.82%. Note that both PWT and UNCTAD data support this ‘level’ effect. PWT data reveals another thought-provoking notion, namely that although trade openness in the UK shows no trend since 1973, for Germany it shoots up after 1999.

5 It is often noted that while for trade in goods the UK has a deficit with respect to its EU partners, the opposite is true for trade in services.

7 Brulhart (2009) shows that the Grubel-Lloyd index (which measures share of intra-industry in bilateral trade) rose from 0.25 in the early 1960s, to 0.4 in 1975, but remained constant at 0.52 for 1990 and 2006.

8 These are preliminary results using the Synthetic Counterfactual Method pioneered by Abadie and Gardeazabal (2003) that we generated for this column. These results are based on a simple model focusing on market size, per capita GDP and trade openness as key determinants of location choice and a similar donor pool to Campos et al (2014). Larger weights were estimated for USA, Canada and New Zealand.